A study by the Reserve Bank of India shows that companies witness a sharp decline in return on assets and turnover ratios in the two years after an IPO
Firms witness a sharp decline in return on assets and turnover ratios in the two years after an IPO, or initial public offering, but is not weak if it is helped by sales which improves profits, says a study by the Reserve Bank of India (RBI).
The central bank uploaded on its website on Tuesday a Working Paper titled “Operating Performance of Initial Public Offering (IPO) Firms after Issue in India: A Revisit” by Avdhesh Kumar Shukla and Tara Shankar Shaw under the RBI Working Paper Series.
The paper says that the initial decline in the ratio of operating cash flow with total assets could be on account of enlarged capital expenditures, which firms resort to after the company goes public (IPO).
“Our analysis indicates that the post-issue operating performance of IPO firms measured as return on asset (ROA) and turnover ratio (TOR) records a sharp decline. However, contrary to the findings of extant literature, we find that the decline in ratio of operating cash flow with total assets is confined to the issue year and year after the issue only,” the study highlighted.
It is found that the operating performance does not deteriorate post IPOs, if a performance indicator like “profit” is normalised by sales volumes (i.e., return on sales) rather than assets (i.e., return on assets), the paper pointed out.
“We also find that as far as return on sales and sales growth are concerned there is no statistically significant change after issue,” the paper adds highlighting the importance of choice of right variables for matching and normalisation purposes.
Normalisation is a process of adjusting non-recurring expenses or revenues so that it only reflects the true earnings or usual transactions of a company.
Empirical results of our study indicate that IPO firms’ ROA (return on assets) and turnover ratios (TOR) record decline after issue while the ratio of net operating cash flows to total assets (RCFA) declines in the first year post issuance but recovers in subsequent years, the paper said.
Net operating cash flow is the amount which the owner can take out from the company in the form of dividend or other distributions.
“At the same time, ROS (operating profit to sales ratio) does not show any statistically significant decline. We find that faster expansion of asset base of IPO firms immediately after issue largely explains the decline in asset-scaled performance variables such as ROA. The decline is not observed when profit is scaled by sales,” it said.
However, ROA remains above the industry median.
The RBI working paper examines how the operating performance of the Indian firms changed after their IPOs based on data on non-financial firms, which floated IPOs during April 1, 2000 to March 31, 2011 and focuses on their long-term operating performance, for which it uses minimum three years post-issue data.
The sample consists of 413 IPO firms, of which largest numbers of issues were floated in 2000-01 followed by the financial year 2007-08.
Average age of IPO firms was 11 years at the time of issue.
According to the study, IPO firms witness a sharp expansion in assets size and capital expenditure in the post-issue period.
The average issue size of sample firms was Rs 216.30 crore (median is Rs 58.4 crore). Average return on the listing day was 20.4 percent (median is 13.7 percent), indicating very high underpricing by many of the firms.
“Median shareholding of promoters and promoter groups in firms declines to 49.7 percent post issuance, from 70.4 percent prior to issuance which is lower than what has been reported by Jain and Kini (1994) and Mikkelson, Partch and Shah (1997) in case of the United States (US),” the authors noted.
Giving a snapshot of performance indicators, the paper said, “Median change in operating returns of IPO firms post issuance relative to year [-1] was (-) 3.0 percent, (-) 4.4 percent, (-) 5.6 percent and (-) 6.2 percent in years , ,  and , respectively.
“Industry-adjusted operating returns also showed a similar trend. Median industry adjusted operating returns in year , ,  and  vis-à-vis year [-1] were (-) 2.5 percent, (-) 3.9 percent and (-) 3.5 percent, respectively,” it said.
The study concludes that the primary reason for the decline in the operating performance is rapid rise in assets of an IPO firm given a consistent decline in ROA and a similar trend in TOR (turnover ratios) in the three years post issuance compared to the matched firms.
Author Shukla is Assistant Adviser in the Department of Economic and Policy Research at RBI while Professor Shaw is a member of faculty at the Department of Humanities and Social Sciences, Indian Institute of Technology Bombay (IIT- B), Mumbai.